S&P downgraded AIG to A-2 with a negative outlook as reported on CNBC (hat tip readers Scott and Michael. I don’t see a link to a press release yet on S&P’s site). Update 9:15 PM, it’s now on Bloomberg. The cut was from AA- to A- on senior debt; the A-2 is the counterparty risk rating.

This downgrade triggers the requirement that AIG post more collateral. I am looking for confirmation, but this is what I saw in terms of consequences. From Bloomberg:

A ratings cut may have “a material adverse effect on AIG’s liquidity” and trigger more than $13 billion in collateral calls from debt investors who bought the swaps, the insurer said in an Aug. 6 filing. AIG has already posted $16.5 billion in collateral through July 31. A downgrade could also set off early termination of swaps that may cause $4.6 billion in payments, AIG said.

The is going to lead to massive counterparty defaults in the credit default swaps market, an event we and others had warned about for some time. The CDS market was the most likely culprit to cause a systemic unwind. God help us if the authorities are not prepared.

I will update this post when news hits the wires.

Update 9:30 PM: Moody’s has also downgraded (headline only at WSJ), and reader Scott gives a summary of CNBC:

David Faber saying they have to raise $75 billion tomorrow, or the BK on Wednesday. Maria B and Larry Kudlow noting that there’s a ton of private equity money dying to dive in, but terrible regulatory environment doesn’t allow it. I knew there was a reason I never watch this stuff.

S&P warned the insurer could face further ratings cuts – perhaps even into the lower BBB category – unless it is able to ”implement further liquidity options” and ”the successful sale of at least a portion of its business assets”….

AIG is the biggest provider of commercial insurance in the US,….

But it also has a financial products division that acted like an investment bank and has been at the heart of the current problems. AIG is a counterparty in a large number of swap and hedging transactions. It wrote credit default swaps, which insure against corporate default, some protecting against losses on collateralised debt obligations, complex financial products that have suffered large losses because many of them were backed by assets backed by mortgages.

S&P said on Monday the main ”source of the strain comes from credit default swaps covering multi-sector collateralized debt obligations with mortgage exposure as well as insurance company holdings of residential mortgage-backed securities”.

The Nikkei is down 618 at this hour. A trading halt was imposed in Korea. Central banks in China, Japan,and Korea have made responses, but not as extreme as the Fed’s $70 billion reserve increase today. Back to the original post:

Alongside the highly complex counterparty issues, Lehman is itself the biggest ever bankruptcy to hit debt markets. This will mean huge payouts on credit default swaps (CDS) bought to protect against losses on its debt, while also causing enormous losses for investors who hold nearly $150bn of its bonds.

Lehman bonds are trading at levels that imply losses on its debt of about $90bn, which assumes a standard recovery rate of 40 per cent. “Insurance companies, mutual funds and money market managers will bear many of these losses,” said Gregory Peters, managing director at Morgan Stanley.

In spite of a specially organised Sunday trading session in New York ahead of Lehman’s bankruptcy filing, the process for banks of working out their derivative counterparty exposures to the bankrupt dealer has only just begun.

In the credit derivatives market, which has been one of the fastest-growing financial sectors – hitting $62,000bn in notional outstanding volumes – short-term volatility and stuttering liquidity were immediately apparent. But the longer term effects on faith and activity in this still young market remain far from certain.

“The derivatives market is shellshocked,” said Brian Yelvington, analyst at CreditSights. “There are many aspects about unwinding trades with Lehman which people just don’t know yet how to resolve. The legal contracts which underpin the markets are not always watertight and this means unintended consequences cannot be ruled out.”….

Eraj Shirvani, a senior Credit Suisse banker and recently elected chairman of the global derivatives industry trade body, insisted that trading had remained smooth given the circumstances of three huge credit events in little more than one week – Lehman’s failure adds to the state bail-out of Fannie Mae and Freddie Mac, the mortgage agencies.

“We could have come to work today and had no trading, no one accepting anyone else’s credit and the market going into total meltdown. The fact that prices are available and that index moves have been relatively limited shows that we have liquidity and that the market is actually operating smoothly,” he said.

However, analysts and traders in the market said that banks were mostly focused on calculating and then looking to offset their own exposures to Lehman first – and so liquidity had been fairly limited. Gavan Nolan, analyst at Markit Group, said the indices had seen their worst ever single-day correction…

Others were not so sanguine. “This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market,” said one hedge fund trader. “Here, we’re all wondering whether Lehman might have blown up the market.”…

Mr Shirvani said that while a central clearing house and other infrastrastructure improvements that are in the pipeline would undoubtedly have helped, the market was capable of dealing with the Lehman failure.

“Compared with the many hedge fund failures seen in recent months, this counterparty failure is much more complicated, the numbers are a lot bigger and there are going to be more bumps in the road, but the process is robust, we have a very good contract and I think the closing out of contracts will happen in an orderly fashion,” he said.

Lehman is the warmup to what we will see with AIG. With Lehman, the issue is the ability of the counterparties on Lehman CDS to make good on their commitments. Because allegedly most of these exposures were hedged with offsetting CDS contracts, the gross amount at risk may considerably overstate the net.

AIG is a completely different beast. It was a massive protection writer, and the belief (we’ll hear more details soon enough) is that it has considerable net exposure. If Bear could not be permitted to fail due to the possible impact on the CDS market, multiply the impact by three or five times for AIG.

It was my experience (but I don’t claim it’s exhaustive) that AIG was typically a protection seller on deeply subordinated tranches. A typical CSO structure would stick AIG with the bottom (or top, depending on how you look at it) 85% for maybe 10-15bps.

If this is a large part of their book, and if they don’t post more collateral, yes they’re in breach of contract, but I’m not certain the CSO trusts would be in breach to the lower down holders unless the structure were not 100% funded.

I realize this is overly simplistic, and I absolutely agree that in a complex waterfall distribution the prospective inability to pay the super senior tranches can hurt everyone in the structure, but the scandal here is that everyone knew aig couldn’t pay all the defaults in a 100-year storm environment anyway.

I’m simply suggesting that so much else is fundamentally so badly wrong with the world of CSO’s and other structures that I don’t think this is going to tip it much further into the s**tpile that it’s already in.

What would be much more “interesting” would be if AIG’s insurer units were downgraded. Most commercial insurance purchases are stipulated to be from a carrier rated A or better by AM Best, and as most policies renew on a calendar year basis you can kiss it goodbye…

Good thing the state insurance regulators aren’t letting AIG borrow money from its insurance subs…

“I think this makes a central clearing house very likely now to help ensure transparency and funding in stressed periods. But the credit derivatives market has become too big an asset class now to disappear.”

CDS contracts range from plain vanilla (with barely a change to the ISDA form agreements) to the incredibly sophisticated and customized contracts where very expensive lawyers on both sides worked hard to justify their fees.

Guess which style AIG favored?

My main point is that those that are counting on an “orderly” “robust” process for close outs (absent uniform settlements) are missing the point. Lehman imploded (as is AIG now) in far less time than it will take to “work through the process”. When that back office reality reaches the right nervous risk managers, we could see panic settlements (where the fastest to the close-out offer will win, and damn the offsets).

Bill Ford, Atl Fed Pres…aig needs to raise 70-100bn. Ford said Fed won’t step in b/c 1.) it will be too difficult to do it in such a short over-night period (i don’t believe that…they’ve had all weekend to flesh out aig)

Now for some of us older types the looming CDS disaster looks a lot like the back room disasters of the 1960’s (really before my stint but institutionally trained memory remains intact). Back then smaller firms were just folded into the bigger ones:“The result was that many firms were poorly equipped to handle the huge surge in business and completely lost control over their paper flows and recordkeeping. The back rooms of many firms were stacked to the ceiling withpapers that had not yet been processed or were being held for unreconciled errors. Payments were not made or were made to the wrong parties; securities were not delivered on time or were lost. By the early 1970s, these problems, complicated by the onset of a bear market, had almost ground the securities industry to a halt. The costs of remedying the back-office problems were tremendous, and between 1969 and 1970, approximately 160 New YorkStock Exchange firms went out of business.”http://www.sec.gov/news/speech/speecharchive/1997/spch199.txt

An AIG derivatives unwind will take decades of litigation. A true debacle.

The threat of any such debacle is exactly what will inspire those “too clever by half” lawyers to suddenly get religion. No sense in litigating out a claim that will ultimately be against a long-ago defaulted counterparty. Better to simply get the front side and the backside to agree on a rough estimate, everyone share the pain and tear the damn thing up. But that “netting session” on Sunday didn’t go so good… so who knows. Maybe debacle it is…

There are three laws. The first is that when the whole is valued at less than the sum of the prices of its parts, some of the parts are overpriced. What this usually means is that you’ve separated out and sold the toxic waste, and you’ve found customers for the Z tranche.

I understand the argument that there are costs involved in breaking apart these instruments and that in fact you are catering to different markets, to people who want to buy something that is more exactly tailored to their needs. There is a reasonable case to be made that you can in fact take an instrument and break it into a number of different parts and that the different parts will sell—even in an honest market—for more than the total instrument.

But I’m still willing to stick with my law because there are ways that you can fiddle with these instruments. When I was on the housing commission for President Reagan, I was involved in the design of the REMIC. As everybody who’s dealt REMICs knows, you have to find the parts that are priced to make the division of the instruments profitable.

The second law states that when you segment value, you also segment liquidity. The second law is absolute. The very factors that allow you to sell the part for more mean that you’ve tailored the instrument to the needs of specific customers. And that means that in the end you have a smaller market for these parts than you might have for the instrument as a whole. That’s demonstrably true.

The third law involves the deconstruction of credit judgment. The rule holds that risk-shifting instruments will tend over time to shift risks to those less able to bear them, because “them as got want to keep and hedge, and them as ain’t got want to get and speculate.” It always turns out that you do business with firms that are B-rated and worse, because you can get the best prices out of them. So there’s an inherent instability in the tendency of credit judgment to deteriorate as you make money going down the credit scale.

I’ve worked on a fourth law, but haven’t come up with the right aphorism. That law will hold that the more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion. When you are comparing things that are extremely dissimilar, and when you have correlations without causes, you are creating the opportunity for contagion—and in a dynamic hedging environment you are indeed creating a virtual certainty of contagion.

For AIG to find itself in this position AFTER having had the opportunity to watch what happened to the monolines earlier this year when the rating agencies got scared, well, that is a serious indictment of Willumstad for being completely asleep at the switch. As soon as they saw the instability in the rating agencies, they should have been moving as fast as humanly possible to de-lever and buy their way out of contracts, even at a loss, in order to avoid the catastrophe of collateral calls. Think about this – three notches in a credit rating has brought the company to the brink of bankruptcy. As of last year perhaps you could have excused them (perhaps!) for thinking their credit rating could never be at risk in any serious way. But after the monoline debacle, there was no reasonable basis for maintaining that delusion. Negligence, pure and simple.

If AIG BKs, you have no concept what havoc will be unleashed. Reader Dwight pinged me with a comment on CNBC from Deutsche Bank Securities Inc. Joseph LaVorgna, Chief US Fixed Income Economist that there will be “financial armageddon” if AIG is not resolved tomorrow.

Was anyone talking about AIG at all a couple weeks ago as having problems, or was I not paying attention?

Those of us that come to websites like this are generally decried as wingnuts for thinking about the chances of a market crash and the aftermath of American policy decisions that are bad in the long-term. It took awhile to come home to roost, but it has. What is everyone thinking about this right now?

As a casual reader I’m not sure what this has to do with anyone who is not involved with AIG or Lehman stock. Yes I understand AIG insures bonds like the monolines as well as CDS crapolla.

So will I not be able to take out cash from my credit union or bank of America account in a week if AIG fails? I doubt it. It sounds like all that mis-allocated wealth given to CEOS was invested in exotic financial instruments.

Too bad for you. I think most of America will cheer as your homes burn. You took everything from them.

The CDS market is far more concentrated than you think on the protection-writing side, and AIG was one of the very biggest protection writers. There aren’t thousands of protection writers to begin with.

Second, the value of the swap is risk dependent, Swaps prices rose to record highs today. The maount at risk took a corresponding leap up.

Frankly your comment indicates you do not know very much about this market.

Wow. This thread deteriorated fast. I love when comments attack Yves for not “thinking things through.” I saw the same basic comments with respect to the problems at LEH, FNM and FRE. Yves is merely discussing the issue and pointing to the views of “experts.”

Slightly off topic…but to me, right now, the main issue here with AIG is contagion. It is not just BSC. It is not just FMN, or FRE or LEH or the notional amounts on any of their individual books. What is meant by contagion is the severe deleveraging that will occur if trust is lost. Without trust that one’s contracts can or will be honored, contracting will cease or will become extremely expensive on a transactions cost basis. Without contracting, asset values (and thus capital in bank and shadow bank institutions) become even more opaque. This could lead to a feedback loop in which massive deleveraging leads to even more massive deterioration in asset values.

We have the most leveraged and complex financial system in the history of the world. Its efficiency disappears without trust. True, no one really knows what’s going to happen if AIG goes down. But I wouldn’t be betting against a complete systemic collapse if firms start BKing one per day and all trust leaves the system.

I think it is a function of trust, but not necessarily in the manner Anon describes. Part of the potential for panic is because there is little need for trust. I know something smells in that black bag you are trying to sell me because I know what I put in the bag I sold to the other guy.

Some of the panic deleveraging will come from the rush to the door not because people don’t know what is under the hood, but because they do.

WaMu embraced Alt-A and now is headed for the gurgler, but who can point the finger?

I may have gotten a bit rough above. I don’t mind when people who are knowledgeable tell me I am off base, but when people demonstrate that they are not terribly well informed.

But separately, there may be a definitional issue. I am not saying that an AIG failure will lead to the entire banking system seizing up. But you will see cascading failures from a train wreck in the CDS market and a bigger-than-Lehman ratchet down in stocks. The loss of wealth alone will have an economic impact. The actual damage will be considerable, and the psychological impact (on risk taking and willingness to lend) will also be large.

I think a failure of AIG would without doubt cause the entire banking system to seize immediately. CP and REPO mkts would become closed or prohibitively expensive to many market participants on top of what is now essentially a frozen CDS market. No ability to finance, no ability to hedge credit, and no liquidity, a death blow.

Under such a scenario the $70b REPO we saw today to pull FED funds back from 6% would be a drop in the bucket…

As for the utility of CDS, I am the wrong person to ask, although others are welcome to speak. I though the whole concept of letting banks trade credit risk rather than do credit analysis was a bad idea from the get-go and would lead to a deterioration in credit standards. That was my reaction when the product was starting out. But I am a risk averse old fart who looked like a dinosaur for harboring that view.

And BTW I have worked with derivatives trading firms who really knew what they were doing, so I am not knee-jerk opposed to complex financial instruments. But only a few are really capable of understanding them, and they were used by way too many people who were not sufficiently skilled or attuned to the risks.

Remember the behavior of the rating agencies when the monolines where under the microscope? They just took their sweet time, obfuscated and spinned the whole thing instead of doing the right thing when everyone and his Mom knew that a significant downgrade in rating was inevitable.

Everyone seems to agree that a AIG BK could have very unpleasant consequences for the financial system, and, by extension to the economy at large.

Yves: Thank you for providing the most cogent, and on the mark, financial web site, and for also assembling the most knowledgeable blogers around. As you already know from my blog posts, I’m just an observer, not an insider. Your site, however, is the only place I’ve found that is willing to speak the truth, the whole truth; well you know what I mean. Bravo for that! The only bright light I’ve found since way back on Sunday night is that “Credit Default Swaps” (CDS’s) have now entered the lexicon of “problems” facing the financial markets. I have been wondering when someone would actually have their mouths so full of them that they would actually say the word. And surprise of surprises they’re even talking about the difficulty of figuring out “trading desk exposures”. Now all I’m waiting for is someone on high to say “Off the balance sheet” and/or “Shadow banking system”, but of course that would take an explanation of why they went so out of control, for so long, for so much, $65T, with no regulation whatsoever. Hmm…not to likely. I would be willing to bet anyone “dollars to doughnuts”, as my dad used to say, that Paulson or Bernanke have never heard of Satyajit Das much less read “Traders, Guns, and Money”.

Hang in there, Yves: We need you on this during the rest of the week. You and the other econobloggers are the surfers on the upslope of the fifty foot wave, so we look to you first to hear the worst and look over the rest!